The Algebris Bullet

The Silver Bullet | Brazil: The Caipirinha Crisis is Just Starting

Millions of Brazilians cheered last week as they watched former President Dilma Rousseff walking out of her post at the presidential palace. We believe the euphoria will be short-lived: Brazil suffers from a variety of structural and deep-rooted issues. Replacing an unpopular president is just the first step of a long tortuous road to restore growth.
[clickToTweet tweet=”Brazilians may have earned a brief moment of joy, but the Caipirinha Crisis is not over.” quote=”Brazilians may have earned a brief moment of joy, but the Caipirinha Crisis is not over.” theme=”style4″]

No time to party

Brazil’s numerous political parties have rallied around a common cause: getting Rousseff out of the Palácio. That was an easy decision given Rousseff’s abysmal approval ratings, which have stagnated below 10% consensus over the past quarters. In practice, however, it wasn’t as straightforward. Brazilian love soap operas – telenovelas – which air every evening at prime time. In a true telenovela spirit, the impeachment was full of twists and turns, with technicalities slowing the process and mainstream singers Caetano Veloso and Giliberto Gil unconditionally defending Rousseff.

But eventually, Brazilian politicians have embraced a multi-partisan approach supporting Temer as interim President. While Rousseff’s coalition was a fragile combination of 7 parties, Temer now receives political support from opposition leader Aécio Neves.

Neves said he is likely to support Finance Minister Henrique Meirelles in his fiscal consolidation strategy. Both Neves and former central bank governor Meirelles opposed Rousseff’s fiscal policies of funding politically-palatable spending through higher taxes – Brazil already has amongst the highest corporate tax rates in Latin America.

In his first speech as Finance Minister last Friday, Meirelles highlighted his priority of stabilising the budget through spending cuts and a reduction of entitlements: “privileges for those who don’t need them”. Opposition to the new government appears low, with Rousseff’s Workers Party – (Partido dos Trabalhadores, or PT), commanding only 11% of seats in the lower house and 13% in the senate, weakened by recent defections.

Yet underneath the euphoria and encouragement for the new government lies a difficult challenge: to revert decades of inefficient public spending and implement politically thorny reforms. Even though it may be tempting for Brazilians to celebrate after many years of Rousseff in power, this is no time to party.

One thing to remember is that at the start of her mandate, even Dilma Rousseff enjoyed a high level of approval. When she was re-elected in 2014 (albeit by a narrow margin), she did so with the support of 8 other political parties and with amongst the highest approval ratings for a Latin American leader at the time. In the last 18 months, Rousseff and the PT have turned into political pariahs. The main driver has been Operation Car Wash (Lava Jato), the multi-year corruption investigation which has involved over 200 public persons in Brazil, including politicians and entrepreneurs.

But investigators have indicated that they will now shift their focus on to the PMDB and the PSDB, who support Temer and Neves. Many of Brazil’s new top leaders are already under investigation, including Temer himself, lower house chief Maranhão (2nd in line to the President) and upper house chief Calheiros (3rd in line to the President). Today’s multi-partisan support for the new government may soon leave the way to political infighting.

Challenges ahead: Reforms, austerity and monetary easing

Like other developing countries, Brazil used credit expansion to boost growth over the past decade. The government increased public debt, but also encouraged the private sector to borrow. Government and private indebtedness increased by around 10pp and 23pp (as a % of GDP) between 2007 and 2015. A sharp rise in borrowing means that investments may have not been allocated efficiently. Some programmes worked to increase education levels and to reduce poverty, like FIES (0.2% of GDP) or Bolsa Família (0.5% of GDP). Others were less justifiable over time, like housing subsidy Minha Casa Minha Vida – “My House, My Life” (1.9% of GDP).

The bottom line is that Brazilians now face a slowing economy and a rising cost of debt, as the central bank hiked rates to keep inflation in check. At the same time Brazil’s largest trading partner – China – is slowing too (see The Silver Bullet | China: Feeling the Stones of Japanification). With China slowing, falling commodity prices and a domestic credit crunch, Brazil is trapped in a combination of problems.

Getting out of the of the Caipirinha Crisis (with a hangover)


These are Brazil’s top priorities, in our view:

  1. Reducing the structural deficit and implementing welfare reforms. Brazil’s finances continue to deteriorate as weak commodity prices hurt miners and their suppliers and tax revenue declines. At the same time, public expenditure remains high, given it is much harder to cut spending in some areas. For example, the country’s generous public pension system costs the government over 7% of GDP every year – one of the highest in emerging markets. Brazil’s government has all but officially abandoned its primary fiscal target, which for 2016 was +0.5% of GDP, but the primary deficit widened to -2.3% in Q1. As a result, government debt continues to rise, with IMF projecting 83% debt to GDP by 2017.
  2. Containing inflation and deleveraging the household sector. With weaker finances, the government’s ability to continue subsidising the private sector has declined. This adds further to the downward pressure on consumption, as households’ purchasing power has already been eroded over time by high inflation. Despite disinflationary pressures globally, Brazil’s inflation remains elevated at around 9.3%. This is both because of the country’s current account deficit, which leaves it vulnerable to inflationary shocks, and to a reduction in subsidies, which had artificially supressed the cost of living. So, Brazilians are still losing their jobs, paying more on their rent and food, and facing rising refinancing costs – the SELIC rate, is still at a six year high at 14.25%.
  3. Restructuring banks and cleaning up NPLs. Despite these unfavourable economic conditions, banks continue to lend. Growth in bank lending has slowed, but remains at around 5-10% YoY, by our estimates based on Q1 2016 financial statements. Continued lending not only masks Brazil’s true pace of non-performing loan growth (which remains apparently low, with household and corporate NPLsat around 4.9% and 4.3%, respectively, in March), but also delays the private credit restructuring Brazil still needs.
  4. Restructuring state-owned corporates. The Petrobras scandal, which has been at the epicentre of Brazil’s political crisis, highlights the increasing inefficiency and structural loopholes in the country’s state-owned enterprises (SOEs). Even before the outbreak of the scandal, Petrobras’ profitability and return on capital had been declining for years, despite its heavy capital expenditure. Most Brazilian corporates are still overinvested and in need to adjust their capex plans. In addition, all major listed firms have heavily borrowed in hard currency, which represents over half of corporate debt.
Conclusion: A Little Party Never Killed Nobody

(but the hangover can be very, very painful)


Getting Brazil out of the current recession and reforming the country won’t be easy. Reducing the fiscal deficit will be challenging, given already high corporate tax rates. Public finances could get worse with the potential need to recapitalise banks or even Petrobras. The bigger challenges lie in implementing structural reforms: re-tooling the economy to reduce its dependence on commodities, improving the efficiency of SOEs and overhauling the pension system. The risk of social unrest remains high, as the new government attempts to implement austerity and reforms and remains under the scrutiny of investigators under Operation Car Wash. Easing monetary policy may help, but eventually tighter capital controls may be needed and in a worst-case scenario of political unrest, Brazil may be eventually forced to request IMF intervention.

Given this backdrop, the recent rally in Brazilian assets appears overdone, and investors’ expectations too optimistic. Brazil’s sovereign and corporate spreads are likely to widen again. In the opposite position as Brazil is Argentina, with little dependence on China and commodities, a new reformist government with a clear agenda, and very low corporate and household debt. It is possible that the two will converge over time.

Brazil is in a unique and tough position, both highly exposed to global macro risks as well as vulnerable to its own political turmoil.  A little party never killed nobody, says Fergie. In Brazil, the party may have just been going on for too long.

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